What Is Restricted Stock?

What Is Restricted Stock

A company may offer its employees stock – without requiring any payment. Or, if there is a payment, it may be at a fraction of the current fair market value (FMV).

These types of grants are known as restricted stock and there are two flavors:

Restricted Stock Units (RSUs)

You will receive stock in the company if you meet certain requirements. The most common is to work at the company for a period of time (this is known as vesting). But other requirements include:

  • Hitting a revenue or profit target
  • Finishing a project

Once you meet the requirement, the company will transfer the shares to your account.

You do not pay any taxes when you get the RSU grant, though. Instead, the taxes are owed only when the shares are vested. For example, suppose you get a grant that is worth $10,000 and after one year it vests. The value is now $15,000. Well, you will pay a tax on the full amount, which is at your ordinary rates.

Although, if you paid some value initially for the stock, then you will do the following:

  • Gross Amount from the sale – the amount paid (known as the costs basis)

So, in our example, let’s say you paid $5,000 at the time of the grant. Because of this, your gain is $10,000.

Now here’s the rub: You will need to pay taxes on the gain — even if you have a tough time selling the shares (this is common for private companies). The IRS will not care!

In fact, the agency will require the company to pay withholding on the income, which will appear on your W-2 (this will include not only the federal and state tax but also Social Security and Medicare). Thus, it will come back to you for the cash to make the payment. But the withholding may not necessarily be enough to pay for your total tax obligation. As a result, there’s a good chance you will owe more taxes when you file on April 15th.

If you are not an employee, then the company will issue a 1099-MISC form that will include the full amount of the value of the stock. In order to not pay penalties, you will probably need to make estimated payments to deal with the tax liability.

So what happens when you eventually sell the shares? You will either have a short-term or long-term capital gain to report. This will be based on the date you receive the stock. That is, if this happened more than a year ago, you will have either a long-term gain or loss.

Confusing?

Well, let’s take a look at an example: You get a stock grant worth $10,000 and make a payment of $5,000. After one year, the stock vests and the total value is $15,000. You will have a gain of $10,000 ($15,000 value minus the amount you paid).

Let’s say more than a year goes by and you sell the shares for $20,000. In this case, you will have a long-term capital gain of $5,000.

How? First of all, you already paid $5,000 but you also recognized a gain on $10,000 – for a total of $15,000. This is your cost basis in the stock. So your gain is:

  • $20,000 sale of the stock – the cost basis of $15,000

Restricted Stock Awards (RSAs)

This is virtually the same thing as an RSU. However, with an RSA, the company transfers shares to your account at the time of the grant (usually, it is placed into an escrow account). If you do not meet the requirements – say working for the company for a period of time – you will forfeit the shares back to the company.

In the meantime, you will be eligible to receive dividends because you own the shares. This is not the case with RSUs (although, some companies pay the dividend anyway). But the tax treatment is not the same for regular dividends. Yes, the IRS has an exception for RSAs! In other words, the agency considers this to be compensation income that is reported on your W-2. This means you will not get the special tax rates for dividends.

At the time of the grant, there is no tax owed since the restricted stock has not vested. Rather, like an RSA, you will not owe any taxes until you get full ownership in the shares. And this happens when they are vested. The gain will also be subject to ordinary taxes, not the favorable long-term capital gains tax. Actually, the holding period of the stock does not begin until the stock is vested.

But there is something you can do to change this: use the Section 83b election. This is done within 30 days of the grant.

If you do this, the IRS will consider that the holding period for the stock has started at the time of the grant. In other words, by the time the stock vests, you should be able to get long-term capital gains treatment.

But you need to report any gain at the time of grant. Example: You get $10,000 in an RSU and pay $5,000. In this case, you will owe taxes on the $5,000 gain on the transaction.

If you expect lots of appreciation in the stock, this is definitely something worth looking at. It could result in large tax savings.

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Tom Taulli

Tom Taulli (Ventura, CA) is founder of the online investment company WebIPO and is the author of The Streetsmart Guide to Short Selling. 10 Illustrations

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